Tuesday, May 7, 2013

Markets may ease the expected "collateral scarcity" problem

In the past couple of years we've seen a great deal of focus on the so-called "collateral scarcity" problem. The new regulatory regime is expected to create incremental demand for high quality collateral such as treasuries, Bunds, etc. This increase will come from Basel III liquidity rules for banks and new derivatives regulation as it pertains to margin requirements. Some of the new regulations combined with central bank activities are also expected to limit the supply.

What makes tracking collateral tricky is that securities such as treasuries are often lent out multiple times. If someone posts treasuries as collateral on a loan, the collateral holder will generally have the ability to use these same securities as collateral for another loan from someone else and so on. That chain acts to provide collateral movement through the financial system to facilitate secured lending such as repo. And given the recent move toward secured lending (see post), access to quality collateral is paramount.

As the attached paper discusses, there is going to be plenty of quality collateral supply in the coming years with governments pushing out more debt into the markets.

Source: Banque de France • Financial Stability Review

The concern centers around what happens to this new supply. According to some estimates, 60-70% of the supply ends up in “non-lendable” accounts. These accounts do not permit lending of securities into the market, restricting the amount of collateral in circulation. Furthermore the new derivatives regulation is expected to force the use of "segregated accounts" - where collateral posted on derivatives positions will no longer be allowed to be lent out ("re-hypothecated"). That is expected to put a further strain on the availability of liquid collateral.

Another reason many are concerned about collateral availability has to do with central banks. The ECB accepts quality collateral for loans it provides to Eurozone banks (MRO and LTRO). That collateral has effectively been "trapped" in the Eurosystem and can not be lent out. Similarly the Fed and the BOE trap collateral through their securities purchase programs.

So far, the collateral scarcity issue has been limited to banks in the Eurozone periphery and mostly during periods of interbank credit crunch. The euro area as a whole, for example, has not experienced a problem with collateral availability.

Reuters: - Some economists have expressed concerns that a shortage of collateral could have a negative effect on bank lending, but ECB policymakers have said in the past that tighter collateral conditions tend to exist only in parts of the bloc struggling most with the debt crisis.

On average, banks had put forward 2.448 trillion euros in 2012 as collateral at the ECB, up from 1.824 trillion euros the year before. The average amount of the use of the ECB's lending facilities was 1.131 trillion euros in 2012.

"The level of over-collateralisation shows that, at the aggregate level, the Eurosystem's counterparties experienced no shortage of collateral," the ECB said in its annual report.

But what about collateral issues going forward? The various forecasts indicate that collateral shortages will be triggered by impending new regulation. That is definitely a risk, but part of the problem with the forecasts on collateral shortage is that they tend to make static assumptions. Here is an example. An Italian bank that owns quality collateral may have had little choice in late 2011 but to use its quality bonds as collateral with the Eurosystem for an LTRO loan. But as demand for such collateral increases, that Italian bank may be able to use the same bonds as collateral for a loan from another EU bank on better terms. Paying 1% to the ECB, as cheap as that sounds, may be more expensive than doing a repo with a bank that really needs that collateral.

While temporary collateral shortages may exist, over time the market will "unlock" more of it. Portfolios that normally don't lend out quality bonds (such as some pensions) will be able to generate extra revenue - especially in this low rate environment - by adjusting their policies. All of a sudden a much larger pool of bonds may become available, driven by higher demand. Between market pressures to unlock collateral and governments more than ready to borrow - now that austerity is out of fashion - collateral scarcity may not be as big of an issue as some have predicted.

Barclays: - ... these are static analyses that do not account for changes in the behavior of investors. Indeed, if the supply of high-quality assets gets scarce relative to demand, the resulting price increase is likely to pull more safe assets out of non-lending custody accounts. Similarly, to the extent that there is balance sheet availability, banks may step in to transform weaker collateral into the high-quality liquid assets required to settle initial margin – for a fee.